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The biggest railroad in the Eastern U.S.,
CSX,
CSX -0.5721551176096631%CSX Corp.U.S.: NYSEUSD31.28
-0.18-0.5721551176096631%
/Date(1438376416032-0500)/
Volume (Delayed 15m)
:
5599576AFTER HOURSUSD31.52
0.240.7672634271099744%
Volume (Delayed 15m)
:
139985
P/E Ratio
15.797979797979798Market Cap
30771294020.2052
Dividend Yield
2.3017902813299234% Rev. per Employee
390750More quote details and news »CSXinYour ValueYour ChangeShort position
has been chugging along for an extended stretch with a bum engine. Demand for coal, a key revenue and profit generator, has dropped sharply in recent years, forcing the company to devise new ways to keep pushing its profits higher. Now the likelihood of more-stable coal demand, coupled with the company's operating improvements, have put the rail operator's shares on an upward path that could have a long way to run.

But the tough new pollution-control standards the Obama administration has imposed on coal miners and the collapse in domestic natural-gas prices persuaded CSX's U.S. utility customers to begin switching to cleaner-burning gas a few years ago, a switch that is occurring globally. Last year, the volume of coal CSX (CSX) hauled to U.S. power generators fell nearly 30%, to 76.3 million tons, off 55% from the 2006 peak. The global economic slowdown has also reduced demand from emerging markets, and added to inventories. Slumping U.S. shipments cost CSX some $500 million in revenue in 2012, and as overseas markets slowed, CSX had to cut transport prices on export coal to hold on to customers.

Unfortunately for the company, CSX has become synonymous with coal's problems to many investors, because of its connection to central and northern Appalachia, thought to produce the "dirtier" sorts of coal the government was targeting. The stock has fallen 20% since July 2011.

"People have looked at the East Coast rails like they're dial-up [Internet] and they're going away," says Peter Nesvold, analyst at Jefferies. The drops are doubly painful because profit margins for transporting coal have been higher than some of CSX's other businesses. By comparison, hauling shipping containers brings in just a third of the revenue per car.

What a lot of Wall Street has missed, however, is CSX's aggressive response to the threat to its business. Remarkably, it has posted record profit in each of the past two years despite essentially flat revenue. It has held the line on costs by mothballing some locomotives and furloughing workers at times. Service improvements like more "on-time starts" mean railcars are in the yard for shorter times, so rent costs don't accumulate. It's also cut its fuel usage per gross ton mile since 2006. Today CSX has an operating ratio (costs divided by revenue) of 70.6%, down from 74.9% in 2009; by 2015, the aim is to get that down to 65%.

TO OFFSET THE DROP IN coal revenue, the company has pushed a number of noncoal-growth initiatives, including transporting containers, moving crude oil, and shipping goods that are benefiting from a recovering economy, such as autos and construction materials. Outside of coal, it moves orange juice from Florida to New Jersey and Ohio, and hauls trash from New York City to waste-to-energy plants in Maryland. The onetime B&O Railroad, the country's first common carrier, will spend $2 billion this year on capital projects including upgrading its tracks.

Sometimes overlooked is CSX's generosity to shareholders. It recently completed a two billion-share buyback, and has taken a third of its stock out of the market since 2006. That has helped earnings per share. In 2012, CSX earned a record $1.87 billion, or $1.76 a share, on revenue of $11.8 billion. Analysts think CSX will earn $1.79 a share this year, on $11.9 billion of revenue.

Unlike a few years ago, the company has a few favorable macro trends running in its favor, such as "the reindustrialization of the U.S. economy, greater consumption, and a longer supply chain that lends itself very well for a railroad in the East where you serve two-thirds or more of the U.S. population," CFO Fredrik Eliasson told Barron's.

True, environmental regulation and cheap natural gas mean some demand is permanently lost. Between 2009 and 2011, 78 coal-fired generators were retired in the U.S. Many more are under way. Nevertheless, as CEO Michael Ward noted dryly in a conference call last month, "On a longer-term basis, I think there is an issue of how we make sure we turn the lights on, so we think some of those remaining coal-fire plants are going to be part of the energy mix in the Eastern half of the United States." Other potentially positive variables for investors to monitor: stable or higher natural-gas prices, more U.S. and Chinese industrial activity, and colder weather.

EVEN IF A COAL BOOM ISN'T in the offing, the decline in shipments is slowing and could reverse in the next year, as supply-and-demand forces equalize. CSX predicts its utility coal volume will fall 5% to 10% this year, a big improvement from 2012's plummet. Pricing is stabilizing in utility coal, too. During the fourth quarter, coal yields held steady at $2,449 per carload from a year earlier.

CSX essentially is a duopoly in the East with
Norfolk Southernnsc -1.7132867132867133%Norfolk Southern Corp.U.S.: NYSEUSD84.33
-1.47-1.7132867132867133%
/Date(1438376802205-0500)/
Volume (Delayed 15m)
:
2563814AFTER HOURSUSD84.33
%
Volume (Delayed 15m)
:
46508
P/E Ratio
14.440068493150685Market Cap
25415965705.9698
Dividend Yield
2.79852958614965% Rev. per Employee
378977More quote details and news »nscinYour ValueYour ChangeShort position
(NSC), so its ability to raise prices is strong as inventories wear down. But the tough new pollution-control standards the Obama administration has imposed on coal miners and the collapse in domestic natural-gas prices persuaded CSX's U.S. utility customers to begin switching to cleaner-burning gas a few years ago, a switch that is occurring globally. By analyst Nesvold's reckoning, the volume gain translates into extra earnings of 35 cents a share that aren't reflected in current CSX forecasts.

Profit is expected to jump to $2.05 a share on revenue of $12.6 billion in 2014. CSX has vowed to keep spending cash flow on stock buybacks and dividend hikes. That spells opportunity for investors. CSX stock trades at 12 times current-year forecasts, the lower end of the range of 11 to 16 it's traded at historically; it yields 2.6%, higher than the market's 2.2%.

Putting a multiple of 14 to his conservative 2014 earnings forecast of $2.08 per share, Nesvold believes CSX is worth $29 a share, more than 30% higher than Friday's $21.97.

The Bottom Line

Shares of the railroad operator could climb as much as 33% over the next year while paying a 2.6% dividend yield. It's diversified and more efficient—and coal demand is stabilizing.

Norfolk Southern should enjoy the same sort of price and volume gains, but its shares are slightly more expensive and its productivity gains not quite as impressive as CSX's.

Richard Nackenson, a fund manager at Neuberger Berman, is a big CSX fan. Nackenson tries to find companies with identifiable, growing cash flows. He figures free cash flow will grow by at least 10% this year. CSX has vowed to use that added cash for dividends and stock buybacks, something that appeals to the money manager. Beginning in the second half of 2013, Nackenson predicts, "the decrease in coal volumes will start to mitigate." In 2014, they'll stabilize.

That said, Nackenson stresses that he's not betting on a bottom in coal demand. CSX, he says, should be to "able to rationalize with productivity improvements and growth in other segments" to meet its goals. A conservative estimate of the stock's worth is $26, or 13 times a profit forecast of just over $2 a share for 2014. Toss in the attractive dividend, and CSX shares look like a true engine of profit.